Financial markets

Austerity

Is opinion shifting?

IF ONE had to tie together the Italian election with Moody's downgrade of Britain, the theme might be that the tide is turning against austerity. Indeed, Thursday's by-election in Eastleigh (a seat in southern England) showed the UK might have its own Beppe Grillo-style disrupting force in the form of the UK Independence Party. But the British downgrade showed that, for all its attempts to please the markets, slow growth in the UK is preventing the government from making a dent in its debt, while Italy showed that voters will eventually reject an austerity policy.

Indeed, this rather damning graph from Dhaval Joshi of BCA Research seems to indicate quite definitively that austerity is damaging economies. The vertical axis shows the growth in GDP per capita since the 2009 low; the horizontal axis, the cut in the structural fiscal deficit (ie the impact of deliberate government policy). There is a very strong and negative relationship which will delight Keynesians everywhere (or rather cause them to shake their heads in disgust).

That said, I think the graph is more relevant to policy decisions in the US and the UK than to, say, Greece. The latter could not continue to run big deficits because it could find no-one to buy its bonds; it has had to rely on official help from the rest of Europe. (The same applies to Portugal, which is the also in the south-west corner of the scatter chart). Non-eurozone members are quick to lecture the creditor nations that they should supply more aid (in the form of cheap loans) to southern Europe with fewer conditions. But it does make a difference when the debtors are not in your country; try asking Congress to fund the Mexican deficit on a long-term basis. The British government has been particularly sanctimonious in this regard.

Another point worth noticing is that the UK has been more aggressive in the use of QE (26% of GDP) than the US (14%) of GDP and has achieved worse results in terms of growth. Of course, this might be down to its proximity to the euro-zone, but it does suggest that fiscal policy is more influential than monetary. And the UK's fiscal policy seems to have been misguided, as previous blog posts have suggested; capital spending has been slashed and taxes increased, while current spending has been rising. This week's leader suggests some ways policy should be refocused.

Regardless of the economics, the politics of this are all very difficult, as this week's column started to explore. Lombard Street Research has just produced a very good note comparing Europe today with the situation in the 1920s and 1930s; the insistence of the Allies in demanding reparations from the Germans, compounded by the initial insistence of the Americans in treating inter-Allied debts as separate from the reparations issue, led to a debt crisis. This was made worse by a fixed currency mechanism (the gold standard) and the attempt to enforce austerity. The result was not just the Depression but the rejection by voters of mainstream parties.

So perhaps we will turn back to fiscal stimulus under the politicial imperative. Will this work? While the belief by some on the right that all government involvement in the economy is harmful seems antediluvian, they are surely right that there is some point at which government involvement becomes too great. The Reinhart/Rogoff rule (that economies slow once government debt passes 90% of GDP) may reflect this point; high debt ratios are a reflection of past deficits, past deficits reflect high government spending, and high spending reflects more government involvement in the economy. Our recent, very positive, special report on Scandinavia showed that Sweden had overdone the big government by the early 1990s and has reformed, and prospered, since then.

So here is another table from David Ranson of Wainwright Economics.

This shows the relationship between changes in federal spending and private sector spending, going back to 1929; the relationship is clearly inverse. Before you reach for the comment button, one point should be made clear; transfer payments(unemploymentbenefits etc) are excluded. So the obvious retort - that this graph merely shows the automatic stabilisers at work - cannot be made.

The idea that government should use the current climate of low rates to finance infrastructure projects that boost the long-term productive capacity of the economy makes a lot of sense, subject to the proviso that governments pick the right projects and manage them well. But one must also allow for the example of Greece; where a country has lived beyond its means for an extended period (by borrowing against future growth), there may be no way of avoiding a fall in living standards.

There are holes in the hull. The ship is filling with water. I know, let's work on the engines! And those drive shafts really need attention . . .
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Greece will certainly have to suffer a decrease in its living standards. But all at once in the middle of a depression? What was a manageable local crisis has become a threat to the existence of the Euro, and all because a bunch of mostly German fools do not comprehend the difference between first aid and long-term treatment.
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And the moralizing is contemptible. Who lent too much money to bad risks? A banker's *job* is to evaluate risk! The lenders have been every bit as culpable as the borrowers.

"Another point worth noticing is that the UK has been more aggressive in the use of QE (26% of GDP) than the US (14%) of GDP and has achieved worse results in terms of growth. Of course, this might be down to its proximity to the euro-zone"
Since January 2008 UK GDP has fallen by 3.1% while eurozone GDP has fallen by less 2.6%
Surly it is the crisis and austerity afflicted economies of the eurozone that are being dragged down by their proximity to the more poorly preforming neighbour.
I know its an ugly competition but I am sick of UK commentators and government blaming their woes on the Eurozone. Germany does not seem to have the same problem

Austerity as practiced currently consists of two very unpopular parts:
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1) Trimming back current programs to free up resources for bank bailouts. Laid off public workers complain.
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2) Additional levies to gather resources for bank bailouts. The additional levies slow the economy.
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Its the insistence on bailing banks out of the global housing bubble (that banks printed) that is very unpopular. Similarly, printing today is all about bailing banks out. Printing regressively takes resources away from those least able to afford it, and gives those resources to banks. Printing to centrally plan asset/home prices is all about maximizing repayment of bank loans.

Between 2000 and 2011 Italy kept a structural deficit constantly in excess of 3% of GDP. Still, during the boom years 2000-2008 that was masked by a cyclical surplus between 0.77 and 2.13% of GDP, allowing the total balance to more or less comply with Maastricht. So the 2000-2008 boom was probably the direct political cause of keeping the structural deficits, rather than its economic effect, as our well-meaning (but very naïve) Keynesan friends love to think today: wrong direction of causal links, as is often the case.
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But then came the 2009 foreign-born recession, with an output gap of –4.5% of potential GDP, and thus the cyclical surplus turned into a deficit of 1.56% of GDP. By 2010 the total deficit grew to about 4.5% and the debt/GDP ratio started increasing substantially. By 2011 it became clear that — although GDP was slowly recovering — interest rates were going up and the structural deficit itself was deteriorating. A fiscal stabilization was thus required to avert a debt explosion. Yet — after some local electoral misadventures during the spring — Mr Berlusconi formally decided in July 2011 to postpone expenditure cuts and tax increases till after the 2013 political elections. The debt markets' reaction was swift and deadly. By November Italy's marginal interest on its debt exceeded 7%. A messy default 3 times that of Lehman began looming.
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That's how Mr Monti and immediate austerity came about. In 2012 the structural deficit fell from 3.49 to 0.67% of GDP, while the debt market had been stabilized by the news since the last few days of December 2011 (long before Mr Draghi's "whatever it takes"). Few today seem to think of what the likely alternative would now have been, had the silly "Keynesian" Mr Berlusconi been left to pursue his default course.

One wonders what the second chart would look like for economies at the lower zero bound. All the evidence suggests that while the fiscal multiplier is usually low (as shown in the second chart), it is very high when the private sector is deleveraging and there is enormous spare capacity (as demonstrated in the first chart). Without crowding out, the argument against fiscal stimulus collapses.
In that respect, while interesting, the second chart has little of value to say for our current predicament. How many more years of failed austerity do we need before the Austerians accept this simple point?

The solution to government overspending is not to hammer the poor but to force wages up and (esp. in Britain) lower the cost of housing. Too many people in gainful employment are dependent on government largesse and too many of the problems of inequality are left to be sorted by the government.

Our recent, very positive, special report on Scandinavia showed that Sweden had overdone the big government by the early 1990s and has reformed, and prospered, since then.
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There's a big difference between 1 country being in the dumper - with different world-wide economic conditions - and numerous large countries throughout the world being in the dumper at the same time.
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NPWFTL
Regards

The idea that government should use the current climate of low rates to finance infrastructure projects that boost the long-term productive capacity of the economy makes a lot of sense, subject to the proviso that governments pick the right projects and manage them well.
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So Japan picked the wrong projects and/or didn't manage them well?
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NPWFTL
Regards

Irresponsible loan origination just to keep the securitization pipeline full is a problem that ought to have been dealt with by Greenspan several years before the bust. He was well informed before the great flood of garbage in 2005-2007, and did nothing.
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I fear that we have learned nothing from what has happened since 2007. It *is* a banker's job to evaluate risk, but if neither bankers' employers nor regulators require it, we are headed down the same path to trouble we took already.

You used to post about how UK government spending was rising and would ask how this could be austerity. In response, people would say that public investment spending was being cut while social safety net spending was up. Are you admitting you were wrong?

I also note there seems to be a spillover effect from the austerity: despite repeated attempts to spur bank lending, maybe the reductions in public investment spending have dissuaded companies from borrowing. I can come up with a few reasons why, including the obvious one, that reducing investment spending while increasing safety net spending is at best bailing a boat to stay afloat while the holes get bigger.

BTW, you have to read the actual paper that discusses the relationship between increases in public spending and decreases in private spending to understand when that occurs. I would also note that R & R's paper is not a rule but an observation that may or may not be true and that it is a political, not economic statement to make it into a rule.

Your sinking ship analogy suggests structural reforms should not be a priority in an emergency. Unfortunately for Greece and (more importantly) most other democracies, there is never a popular mandate for structural reforms except in emergencies. My own nation is the same.

The Germans are not fools for not lending more, they are fools for lending at all. The Greeks wont pay them back, wont thank them for their help, and wont "work on the engines", either in an emergency or in a boom or at any time before the Sun swallows up the Earth.

Complaints about the moralizing and incompetence of creditors seems irrelevant, if you don't like someone then don't take their money.

And if someone is incompetent for lending money then why should they be pressured into lending more?

All the leftist thinking on the Euro crisis is like Bamps post, full of emotion, muddled thinking, inconsistent even with itself, and essentially fantasist.

Debts cannot be incurred forever and ever, one day they have to be paid back or why would people lend in the first place. Leftists hate this aspect of reality and that's why their logic gets so convoluted and confusing as they try to talk themselves into a different and perfect world.

compounded by the initial insistence of the Americans in treating inter-Allied debts as separate from the reparations issue, led to a debt crisis.
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Keynes thought the amount of German reparation the Allies demanded was excessive.
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The Germans tried to print their way out, and that failed.
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Then the Allies put together the Dawes Plan.
. After World War I, this cycle of money from U.S. loans to Germany, which made reparations to other European nations, who paid off their debts to the United States, locked the western world's economy into that of the U.S.
.http://en.wikipedia.org/wiki/Dawes_Plan
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The Dawes Plan failed and was replaced by the Young Plan which further reduced reparations.
. Between agreement and adoption of the plan came the Wall Street Crash of 1929, of which the main consequences were twofold. The American Banking system had to recall money from Europe, and cancel the credits that made possible the Young Plan. Moreover, the downfall of imports and exports affected the rest of the world. By 1933, almost two-thirds of world trade had vanished.
.http://en.wikipedia.org/wiki/Young_Plan#Subsequent_Events.
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Initial reparations were 269 billion gold marks, which was reduced to 226 billion gold marks in 1921.
The Dawes Plan reduced it to 132 billion gold marks.
The Young Plan reduced payments to 112 billion gold marks.
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There's the difference.
Germany was forced to take on debt, European countries today went into debt of their own free will.
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NPWFTL
Regards

You, also, apparently are unable to distinguish between first aid and long term care. And you seem to have skipped over my sentence about Greeks having to accept a lower standard of living.
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I can tell you're just an ideologue. You don't have to pay attention to what anyone else might have to say.

If everyone saves at the same time, demand falters and we are going into recession. Americans are paying back their loans at an impressive rate right now, so if the governments does the same it just won't work. Monetary policy doesn't work either in this scenario, even if I can borrow at a very low rate, who is going to buy my stuff? This is rather easy to understand, I always wonder why Americans have such a problem with it. Maybe it is confused with government spending in general or dissatisfaction with their political class? You can reduce government later on, but not in one of the greatest depressions ever! Somewhat related to this issue: Can anyone explain to me why relatively poor Americans would have voted for Mitt Romney? Honestly, I don't understand it, so please let me know your thoughts.

"That said, I think the graph is more relevant to policy decisions in the US and the UK than to, say, Greece. The latter could not continue to run big deficits because it could find no-one to buy its bonds; it has had to rely on official help from the rest of Europe."

I wish this point were made more often. Those saying Greece et al. should cut their deficits less aggressively have not themselves been in any great hurry to buy Greek etc bonds.